Ch1.

1
Financial Market- collection of people and firms that buy and sell securities or currencies Well functioning financial system makes it more efficient for money to flow from savers to investors Savers: have an excess supply of available funds- does not mean they have money to burn; right now they dont have an opportunity to use their funds to get a high return; usually a household, but can be a firm Investors: have the opportunity to invest to gain a higher return but do not have the funds to do so; firms, government What is traded in the financial market? 2 types of financial assets: Currencies and Securities Security- Claim on some future flow of income, such as a stock or bond o Bond (fixed income security/contract or debt security) - security that promises predetermined payments at certain points in time. o At maturity (5 years), the bond pays its face value (FV= $1000) o Before that the owner may receive coupon payments (Ex: 5%) every year for the life of the bond, we will pay you 5% of the face value ($50 a year) o A bond is a loan that you can buy or sell (fixed payment loan) o Bonds with maturities of less than a year are called COMMMERCIAL PAPER when issued by corporations and TREASURY BILLS when issued by government Used for short term liquidity aka short term cash o Buyer knows exactly how much hell get back at the maturity date o Zero-coupon bonds yield no payments until it matures, but usually pays MORE than its initial cost when it matures Discount Bond: has no coupon rate: borrow $1,000 next year pay $1,000 + 5% o Coupon rate is set as close to possible as the market rate, but will differ between types of bonds but it depends on the risk of the firm/government, what is the value of the bonds in the market? o Ex. You buy bond for 100 and receive 6 dollars (coupon payment) a year for 10 years. After ten years (maturity date) the 100 is paid back. Essentially buyers of bonds loan out money to people o Interest- payment for the use of borrowed funds o Default- failure to make promised payments on debts o Risk usually greater among new or failing corporations Stock(equity)- ownership share in a corporation o Higher risk/return than bond o Have control over a corporation. ex. Elect board of directors

Stockholder AKA Residual Claimants when a company has return on their profit, they have to pay the bondholders first; what they have left over (the residual) is available to stockholders

1.2 Why are financial markets important for economy? 1. Securities markets channel funds from savers to investors with productive uses for the funds 2. Help people and firms share risk Savers- people who accumulate wealth by spending less than they earn Investors- people who expand the productive capacity of businesses Diversification- the distribution of wealth among many assets, such as securities issued by different firms and government Mutual Funds- Financial institution that holds a diversified set of securities and sells shares to savers

1.3 Asymmetric information- the problem that one side of an economic transaction knows more than the other o ADVERSE SELECTION: Usually the sellers of financial securities know more than the buyers which affect the value of the securities Ex: A loan officer at a bank has 2 different people coming in to make a presentation on why you should give them a loan. Both want to start a business. One is very experienced in giving the presentation and it is the others first time. Without knowing more information, obviously the more experienced person has a higher probability of getting the loan. So we give it to them, but they have defaulted on 5 loans in the past 3 years and the other person would have been the better choice: Adverse Selection. The probability that the people who are the higher risk of getting the loan are the ones who are more eager to get the loan and more likely to get the loan Adverse Selection- problem that the people or firms who are most eager to make a transaction are the least desirable to parties on the other side of the transaction The good borrowers are the ones not getting the loans o MORAL HAZARD: After investors sell securities they know more than security holders do about their uses of funds Moral Hazard- the risk that one party to a transaction takes actions that harm another party

After receiving the loan, the borrower does something that makes it more likely that they will default on the loan (ex: try to double it on Roulette, or they spend all the money to buy a building, but fail to buy fire insurance)

1.4 Financial Institution (financial intermediary)- firm that helps channel funds from savers to investors Bank- Financial institution that accepts deposits and makes private loans o Savings and Loan Associations are usually smaller and much of their lending is to people buying homes Investment Bank- helps companies issue new stocks and bonds only. Doesnt accept deposits or make loans Traditional banking: using deposits to give out loans Commercial Banks- very large, lend for numerous reasons; can give any type of loan; big in buying securities; owned by one or a group of people Savings and Loans (S&Ls): primarily give out mortgages Mutual Savings Bank: tend to be smaller; depositors of the bank own the bank; the more you have deposited, the higher the ownership Credit Unions: smallest banks; owned by depositors; credit unions are tax exempt because a credit union is formed around a group you have to be a part of o Ex: Campus Federal have to be a faculty, student or related to one o Private Loan- Loan negotiated between one borrower and one lender Indirect Finance- Savers deposit money in banks that then lend to investors Direct Finance- Savers provide funds to investors by buying securities in financial markets Covenant- provision in a loan contract that restricts the borrowers behavior Indirect Finance- savers deposit money in banks that then lend to investors. Ex. Banks give money to investors and also invest in the financial market o It is more efficient to go through banks because banks can do it at a lower cost than we can Direct Finance- savers provide funds to investors by buying securities in financial markets

Banks

Eliminate adverse selection by screening potential borrowers with hired professionals who decide which business is best to invest in Reduce moral hazard with covenants in loan contracts. May require that a business use funds only for specific purposes like business related expenses, which monitor spending and demand money back in the case of reckless spending. Investors in the bank earn less interest than with direct finance, but they hold much less risk. Analysts also reduce moral hazard and adverse selection

Small businesses cannot be funded by direct finance generally, because people do not know much about their business, banks usually take charge Individuals cannot issue financial securities 1.5 Economic growth- increases in productivity and living standards growth in real GDP Real Gross Domestic Product (REAL GDP)- the measure of an economys total output of goods and services Microfinance- small loans that allow poor people to start businesses Centrally Planned Economy- system in which the government decides what goods and services are produced, who receives them and what investment products are undertaken Saving increases GDP US has policies which force companies to issue annual reports investments and earnings which makes savers less aware of adverse selection. Also, provide insurance for banks to encourage financing through banking Stock market capitalization- value of all stocks in a country Large Banks Unit banking customers can only make deposits or seek loans from one location increased banks costs by keeping them small if towns economy did poorly many borrowers defaulted on loans decrease diversification and competition among other banks Large banks benefit from economies of scale, more efficient than small banks Financial development has proven to increase economic growth How Soviet Union Fucked up: Too many resources in prestige (ex. Heavy industry, space program, etc) Over emphasized short-run increases in productivity and ignored long-run investments like infrastructure Factory managers were graded annually and would not halt production to invest in longer-term methods of increased development Managers were awarded based on following orders, not using creative ways to increase input

Ch 2.1
She has a lot of money could mean she is wealthy; could be carrying a lot of cash; high income

Money- anything that is used and accepted in payment for goods and services; class of assets that serves as an economys medium of exchange Functions of Money 1. Medium of exchange- whatever people use to purchase goods and services 2. Unit of account- measure in with prices and salaries are quoted 3. Store of value- form in which wealth can be held 4. Money is the Standard of Deferred payment: Credit cards are NOT money!! When you buy with a credit card, you are taking out a loan; you are deferring payment on that purchase to a later date; you pay the bill with MONEY 5. Unilateral Transfer: public debts; you pay money and it is transferred to someone else Money Demand- amount of wealth that people choose to hold in the form of money Barter- system of exchange in which goods and services are traded directly, with no money involved Double coincidence of wants- condition needed for barter: each party to a transaction must have something the other wants

2.2 Types of money

Commodity money- valuable goods and services used as the medium of exchange (ex: Salt Bars in Ethiopia; Aztecs use Cocoa); to the people who are using it, it has INTINSIC value Fiat money- money with no intrinsic value; only has value because it is money, otherwise it is worthless o Zimbabwe had over 1mill% inflation; they were seizing farm lands from white farm owners and giving it to the blacks and productivity at the farms went south; they began making $1 bill dollar bills to pay for a loaf of bread; they just kept printing money until it went to 100 trillion; eventually shop owners stopped collecting it and currency collapsed o Fiat money does not have to be issued by the government o Community money Is legal in the US; a community develops their own currency

Alternatives to National Currencies Currency board- institution that issues money backed by a foreign currency; any citizen can exchange a national currency unit for unit with a non-national currency; o Ex: Hong Kong, Bulgaria o Fear of inflation rate causes countries to use this Currency union- group of countries with a common currency Dollarization- use of foreign currency as money. i.e. using US money in El Salvador

2.3 money today Money supply- total amount of money in the economy Monetary aggregate- measure of the money supply (M1, M2) M1- Federal Reserves primary measure of the money supply o The sum of currency held by the nonbank public, checking deposits and travelers checks o The currency in circulation + checkable deposits(checking accounts etc.) +travelers checks o A savings account is more liquid than equity on a house o M1 is the most liquid of all assets M2-Savings Deposits + Small time deposits (value of CD is less than $100,000)+ Retail MoneyMarket Mutual Funds (Mutual Funds buy short term bonds) o M2 is 4X M1 When transferring money from Savings to Checking, M1 increases and M2 stays the same M1 M2

Payments system- arrangements through which money reaches the sellers of goods and services Store sends your check to the Feds, the Feds contact your bank and say Hey, we have this check, we need the funds. The bank then electronically transfers the money to the Fed who then gives it back to the store. The paper check is then destroyed The Fed is responsible for making sure the check clears Stored-value card- card issued with prepaid balance that can be used for purchases E-money- funds in an electronic account used for internet purchases 2.4 liquidity and broad money Liquidity- ease of trading an asset for money M2- broad measure of the money supply that includes M1 and other highly liquid assets (savings deposits, small time deposits and retail money-market mutual funds o Savings deposit- MMDA (money market deposit account, possible to write checks but only six a months o Small time deposits (certificate of deposit)- savings account expect deposits are made for a fixed period (.5 3 yrs). Worth less than 100,000 o Retail money market funds- nota bank account. Mutual fund that holds bonds with maturities of less than a year: treasury bills and commercial paper Sweep programs- banking practice of shifting funds temporarily from customers checking accounts to money-market deposit accounts

2.5 Functions of Central banks Monetary policy- central banks management of the money supply Lender of last resort- Central Banks role as emergency lender to banks Clearing Payments (Clearing Checks)- every private bank goes thru Fed (Banks Bank) Financial Regulation- regulate private banks

2.6 The rest of this book Financial Markets- prices and returns on securities like stocks and bonds. Firms and savers decisions about which securities to buy based on risk and how to reduce or increase risk/return. Foreign currencies, why currency values fluctuate and how these changes affect the economy

Ch 3.1
Future value- value of a dollar today in terms of dollars at some future time; o $1 today=$(1+i)^n in n years o Ex if banks pay interest at a rate of 4 perfect and you deposit a dollar today it grows to a $1.04 in a year. In two years its worth (1.04)^2 and (1.04)^3 in three Present value- value of a future dollar in terms of todays dollars; o $1 in n years= $1/ (1+i)^n today o Ex with a 4 percent interest rate the present value of a dollar in n years is $1/ (1.04)^n present value of a dollar in 3 years is 1/(1.04)^3=.889. present value in 20 yrs 1/(1.04)^20=.456 o Higher in interest rate reduces the present value of future money o For payments over multiple years the present value is affected by the interest rate more each year assuming it stays constant. Ex. A salary of $13 a year for 3 years with an interest rate of 4%= (13/(1+.04))+(13/(1+.04)^2)+(13/(1+.04)^3) o Payments forever- can be simplified to Z(investment)/I (interest) o The PV of a future payment in year from now is Investment/1+i^n

Perpetuity having constant payments Ex: Instead of having a fixed payment, payments are tied to the inflation rate. We have a constant growth rate of g

The Federal Reserve Board Case- The Beige Book

When the Feds policy committee meets to decide what to do with policy the members are provided with 3 separate reports. They are named by the colors: Green book: current condition/trends & not released for 5 years Blue book: summary of financial market conditions and has conditional forecasts classified forever, never publicly released Beige book: no numbers at all; they survey firms in their district, released to the public 2 weeks before the committee meets The economy is continuing to expand, even though some say it is slowing down. Not all parts of the country are expanding, but these books let us know what parts are succeeding. Manufacturing is offering consistent jobs and production. Consumer spending is mixed. Consumer spending is 70% of GDP and is the driving force of the economy. We need to see a robust expansion of consumer spending. Real estate is weak; non residential is completely dead and residential is stable but not growing.

Agricultural is unfavorable across most of the nation: floods, drought, increase in food prices Labor Market conditions improve graduallywhy in the US are we different? Our labor market is flexible In the past couple years with housing market as bad as it is, people owe so much more than their house is worth, so people have no incentive to move. Housing prices are as low as they were in 2009 at the end of the crisis. So the skilled workers cannot go to where the jobs are. So our labor market is much less flexible than it was, so the unemployment rate is not going to get better until housing gets better.

Unemployment Insurance Weekly Claims Report Case

When someone loses their job, they are eligible for unemployment insurance. To claim it you go to the local Department of Labor and file for the insurance. You have to do this every week you are unemployed and that you are actively searching for employment. It looks at 2 things: how many people in the past week have come in for the first time? And, how many people are returning? His graphs for insurance claims spike at the end of the recessions because the labor market is a lagging market o If the average is below 300,000 then it is consistent with a growing labor market; given the current population dynamics, for the unemployment to remain constant, we need to have a monthly increase in jobs of 200-250,000 o If the initial claims numbers is above 400,000 it is consistent with a shrinking labor market o The last unemployment report, we had an increase of 188,000 jobs to an increase of only 54,000 the next month. o Initial claims helps predict the changing number of jobs and the unemployment rate.

Classical theory of asset prices- price of an asset equals the present value of expected income from the asset o Ex: 5 year bond has a 5% coupon rate and $1,000 face value So what is the price of the bond today? We are receiving coupon payment every year for 5 years and face value and the end. What is the PV today? PV= $50 + $50 + $50 + $50 + $50 + $1,000 1+g 1+g^2 1+g^3 1+g^4 1+g^5 1+g^5 What is the relationship between price and yield? There is an inverse relationship between price and bond yields. VIP!!! The yield does not necessarily equal the return. If a stock is not currently paying any dividends, they are keeping all of their profit as retained earnings, how do we use the classical theory? Eventually they will pay dividends; maybe we will expect dividends in year 11? You do not know for sure what the dividends will be but you have an expectation. Since we cannot assume what the dividends will be, we have to look at what will affect stock prices through the classical theory. We have to make an assumption: dividend payments will increase constantly each year by a constant rate g Gordon Growth Model: P= D/ (1+i) + D2 (1+g)/ (1+i) ^2 + D3 (1+g) ^2/ (1+i) ^3

Ex: What if the price of the bond was $800 then the yield must be 10.32% Price Yield $900 7.47% 1000 5% 1200 .89% **By looking at this table, we can tell that when the price equals the Face value the yield = the coupon rate Ex: I know 5 years from now I need $1,000 to pay a bill. So I have decided to put away just enough today, come back and have $1,000 exactly. I have found 2 potential accounts to do this in. Both accounts have guaranteed that the interest rate will remain fixed for 5 years. One will pay me a 3% interest rate; one will pay me a 5% interest rate. I get to put less away to get my $1,000 with the 5%. Rational expectations- theory that peoples expectations are the best possible forecasts based on all public information o We have an expectation of what future dividends are going to be D/ (1+i) + D2/(1+i)^2 + D3/(1+i)^3

o o

If an asset is valued at 20 but sells for 15 then buyers win. Conversely, if its worth 20 and sells for 25 sellers win Payments for bonds (C=coupon payments, F=Face value, T=Maturity year): C/(1+i) + C/(1+i)^2+(C+F)/(1+i)^T. ex. Bonds maturity is 3 years, 5 dollar coupon payments 5 percent interest. 5/(1+.04)+5/(1+.04)^2+5/(1+.04)^3

Stock prices- D1/(1+i) + D2/(1+i)^2 + D3/(1+i)^3 Dividend- payments from a firm to its stockholders o If dividends are not paid in one year then the difference will turn over the next year. Earnings and dividends have same value Ex. If a company is about to introduce a product that is expected to yield a high profit then stock price will rise. This is because of what people EXPECT the price to be in the future

How can we measure the amount of risk associated with an investment? If you are going to invest, you should have the potential for more reward. If there is more risk, the value of i should be higher, so we split i into two components: Safe interest rate (i^safe)- interest rate that savers can receive for sure; also, risk-free rate; almost zero chance of a default risk o US Treasuries have a safe interest rate; they have never defaulted on their bonds. But if the government chooses to raise the debt ceiling, they will default for the first time Risk premium- payment on an asset that compensates that owner for taking a risk o Higher risk premium reduces an assets price because high risk induces higher interest rates o Interest rate is sum of the safe rate and the risk premium In conclusion, i= risk + safe Fluctuations in asset prices If there is a change in the economys safe rate or a risk premium Change in income Change in interest rates has a larger effect on prices of long-term bonds than on prices of shortterm bonds Ex: Federal funds are the loans between banks, so the Federal Funds rate is the rate banks charge each other. It is usually between 0-.25%; The Fed cannot lower them anymore, so the only way to move is up. When the Fed raises interest rates, it will reduce the money supply, decreasing the growth rate of the economy; GDP will go down. So firms profits will go down, so the future growth of dividends will go down (Gordon Growth model). So lets look at a situation where the Fed is going to increase interest rates. Three things happen immediately:

1. Safe Interest Rate will rise: Interest rates move together, when one goes up, they all go up. 2. Risk premium will rise (since they both rose, the overall interest rate has risen) 3. Growth rate declines PV of expected income will go down, so stock prices will do down. Ex: Coupon bond with FV=$1,000 Coupon rate is 5%; we are going to assume we are looking over a one year span. Currently the yield on all of the bonds is 5% and the yield on all the bonds one year from now is 6%. Years to Maturity P0 P1 (yield is now 6%) CG RET 30 $1,000 864.09 -13.60 -8.66 20 $1,000 888.42 -11.16 -6.60 10 $1,000 931.98 -6.89 -1.89 5 $1,000 965.35 -3.87 +1.53 1 $1,000 $1,000 0 5% Given this information, what can we say for certain, what can we say about the volatility of prices? The longer term the maturity, the more it will be affected by interest rate change. o Stocks will have more volatility than bonds, because the bonds will go away but stocks have no maturity date. What is your rate of return for holding a bond? If you buy a bond today and hold it until maturity, the yield will = the rate of return. However, if you sell the bond before it matures your actual rate of return may be very different than the yield. If we hold the bond for 1 year, we receive 1 coupon payment. Current Yield + Capital Gain Current Yield: price of value today = coupon rate Capital Gain: for 1 year bond, capital gain is 0, but for all the other bonds, there is capital loss and the longer the maturity period, the larger the capital loss

Asset-price bubbles
Asset-price bubble- rapid rise in asset prices that is not justified by changes in interest rates or expected asset income o Asset price rises because people EXPECT it to rise. Buyers buy stock and because of this stock prices rise, causing a domino effect of increased prices based solely because buyers THINK its more value. This causes the price to rise and so on and so forth. People who buy into a bubble at its peak will lose a lot of money when it bursts and loses much of its value The house market rose by 71%, why? House living: buy a house, fix it, sell it 1. Belief that prices will continue to rise

2. Increase in the availability of mortgages given to people, who perhaps shouldnt have them ex: Interest Only mortgage: pay no principal for first 5 years then you get hit hard; people could no longer afford their mortgage and the market crashed 3. Since April 2009 housing prices have fallen by 33%

.com Company crashed. People bought tons of stock because they thought it was an internet company and anything with the internet was booming, but it was not an internet company. How can we figure out if there is an asset price bubble?? o Price-earnings ratios (P/E ratio)- a companys stock price divided by earnings per share over the recent past o Prices will go up at a much faster rate than earnings o First problem: could have a situation where P/E is overly sensitive, may predict a bubble when there is not one Asset-price crashes Asset-price crash- large, rapid fall in asset prices. Black Monday October 1929 & Black Monday October 1987 o 1929- fell by 13%- bubble crash o 1987- index fell by 23%- technical crash o 1929 is the popping of a bubble, stock prices were rising o 1987 there was no bubble, there is more computer programming and there was an unforeseen problem with computer trade ex: A computer will say If price of stock reaches $X.XX then sell! Computers began to sell stock o Both events were large enough, but after 1987 there was a quick recovery, 1929 was followed by the Great Depression o You can regulate all you want, you are never going to have a perfect regulation that will prevent a crash, however, you can isolate what the main reasons for the crash was and you can have a regulation in effect that will say a crash wont happen again in the same manner Margin requirements- limits on the use of credit to purchase stocks. Stock purchasers must pay for at least 50% of the cost with their own money o There were some traders in 1929 that were selling short: you dont have the stock, you borrow the stock and sell the stock hoping it will fall in value so you can then buy it, make $ and pay off loans Traders were selling stock like mad & made millions in one day Government decided they needed to stop people from doing this so they developed a margin requirement ex: You borrow $50,000 of stock, with the margin requirement you have to put up $25,000

Circuit breakers- requirement that a securities exchange shut down temporarily if prices drop by a specified percentage (around 15%; New York stock exchange) o These were made as a result of the 1987 crash o There is no single person who caused this crash, it was the computers o All trading stops o Last time a circuit breaker went into effect was 2008

Measuring interest rates and asset returns Yield to maturity- interest rate that makes the present value of payments from a bond equal to its price Capital gain- increase in an asset holders wealth from a change in the assets price Capital loss- decrease in an asset holders wealth from a change in the assets price Return- total earnings from a security; the capital gain or loss plus any direct payment (coupon payment or dividend) o Return= (P1-P0)+X. P0 is initial price of security. P1 is price after you hold it for a year and X equals the direct payment (such as a coupon payment, dividend, etc) Rate of Return- return on a security as a percentage of its initial price rate of return= ((P1P0)/P0) + (X/P0). Return/P0 o Ex. Buy bond for 80 then one year later the bond makes a coupon payment of 4 and price rises to 82: ( (82-80)/80)+(4/80) Although stocks are more volatile than bonds they possess a high AVERAGE return than bonds. Stocks buyers are provided risk premium-higher average return Real and nominal interest rates Nominal interest rate (i)- interest rate offered by a bank account or bond (in a particular time period) Real interest rate (r) - nominal interest rate minus inflation rate: r= i- o Ex if bank pays a 5% nominal interest rate and inflation rate is 3% then the real interest rate is 5%-3%=2% o The real interest rate is the one that effects the economy o Real rates can be negative; currently in the US we have negative real rates; we actually dont know today what the real rate is, only the past, because we do not know the exact inflation rate of right now; therefore they have developed a post/ante Ex ante real interest rate- nominal interest rate minus expected inflation over the loan period o Today we make our decisions based on the ante Ex post real interest rate- nominal interest rate minus actual inflation over the loan period o Now we know what the actual inflation rate is, so we can see how we predicted Many do not invest in this product because they dont understand its benefits Real Interest rate is more important indicator of wealth than nominal Uncertainty about inflation makes it risky to borrow or lend money

Ex: what if we have the actual inflation rate > than expected inflation rate? the borrower is better off because the post rate will be less than you anticipated In 1987 US began issuing Treasury Inflation Protected Securities aka TIPS o The payments on these bonds are tied to the inflation rate, so your payment will increase each year the same as the measured inflation rate o Inflation-indexed bond- bond that promises a fixed real interest rate; the nominal rate is adjusted for inflation over the life of the bond. Eliminates anxiety from uncertainty o Ex: suppose we have 2 bonds: both are 5 years, $1,000 FV & coupon rate: 5% One bond is normal: Yield is 5.05% (i) Second bond is the TIPS: We do not know exactly what the inflation rate is going to be, but we have an expectation, so the measure of the TIPS is the measure of the real interest rate: Currently: 3.25% (r) 5.05 3.25 = 1.8% expected inflation rate Traders of the TIPS expect the average annual inflation rate to be 1.8% over the next 5 years

The Federal Bank of Cleveland came up with a new way to measure inflation

The Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation is 1.86 percent. In other words, the public currently expects the inflation rate to be less than 2 percent on average over the next decade. The Cleveland Feds estimate of inflation expectations is based on a model that combines information from a number of sources to address the shortcomings of other, commonly used measures, such as the "break-even" rate derived from Treasury inflation protected securities (TIPS) or survey-based estimates. The Cleveland Fed model can produce estimates for many time horizons, and it isolates not only inflation expectations, but several other interesting variables, such as the real interest rate and the inflation risk premium

Liquidity Trap: need to have 3 criteria: 1. 0 nominal interest rates 2. Have to be in a recession 3. Have to have a negative inflation rate This is worse than having a high inflation rate; if you go into recession, it will cause crisis to fall further; it has a spiral effect

Chapter 4
Each interest rate is a real rate, r, defined as the nominal rate, I, minus inflation, , over the previous year The model we are going to use to calculate interest rates is a long run model To determine your expectations of the current rate, look to the past: adaptive expectations o Actual rates are closer to the rational expectation, rather than the adaptive o But people tend to estimate closer to the adaptive, this is what we assume o In the short run, if we assume people make their expectations adaptively, they are not going to change it day to day, so if the rate doesnt change, the nominal rate will change the real rate Theories about interest rates: Determined by the supply and demand for loans Determined by supply and demand for money Loan-able funds theory- real interest rates are determined by the supply and demand for loans o Basic Assumption: there is no indirect finance: savers and investors are dealing directly with each other in the markets o Demand for loan-able funds aka demand for investments (physical assets) o Supply has 2 components: 1. Domestic Savings: how much of our domestic savings are going out/in the country?? 2. International Movement Capital inflows- funds provided to a countrys investors by foreigners o Capital is coming into the country Capital outflows- funds provided to foreign investors by a countrys savers Net capital inflows= capital inflows - capital outflows Supply of loans= saving + capital inflows capital outflows

If domestic interest rate increases, foreigners want to take advantage of it and capital inflow increases POSITIVE NET INFLOWS RAISE SUPPLY OF LOANS ABOVE THE LEVEL OF SAVING. NEGATIVE DO THE REVERSE

High real interest rate makes investment more costly Lower investment means that investors want fewer loans Loan Demand Higher real interest ratelower investmentquantity of loans demanded Loan Supply Higher real interest ratehigher saving Higher real interest ratehigher capital inflows and lower capital outflows Higher net capital inflows Higher real interest rateincreased saving and higher net capital inflows Quantity of loans supplied

Interest rate is the price of a loan Demand for loans=investment Determinants of interest rates in the loan-able funds theory Interest rate changes when there Is a shift in the supply or demand for loans Higher rate raises the quantity of loans supplied and reduces the quantity demanded Anything that makes investment more or less attractive shifts the demand curve Shifts in saving (supply for loans) Increase interest rates is attractive to loaners (savers) so they produce more Private saving- saving by individuals and firms Public saving- saving by government (tax revenue minus government spending) Budget surplus- positive level of publics saving Budget deficit- negative level of public saving Capital flight- sudden decrease in net capital inflows that occurs when foreign savers lose confidence in an economy Fisher equation- the nominal interest rate equals the real rate plus expected inflation; i=r+ Adaptive expectations- theory that peoples expectations of a variable are based on past levels of the variable; also, backward-looking expectations Public saving=tax revenue- government spending Deficits raise the real interest rate

Liquidity preference theory Liquidity preference theory- the nominal interest rate is determined by the supply and demand for money. Demand for money is sometimes called :liquidity preference o Assume only two assets exist-money and bonds Money is medium of exchange. People use money to purchase goods and services; they cant use bonds Bonds pay interest but money does not Money supply is total amount of money in the economy. Controlled by central bank. If fed wants to increase $$ then it prints money to buy bonds which are then dispensed to the economy If fed wants to decrease $$ then it sells bonds and shreds the money

Nominal interest rate on bonds is the opportunity cost of money Higher interest ratesless quantity of money demanded Because money supply is fixed according to Fed, regardless of interest rates, the money supply curve is vertical In the liquidity preference theory, changes in equilibrium interest rates are caused by shifts in money supply and money demand The money demand curve shifts if people change the level of money they hold at a given interest rate People hold more money when they spend more For the economy as a whole, the demand for money rises when total spending rises Nominal GDP=real GDP X aggregate demand Loanable fund theory- Interest rate is determined by the supply and demand for loans. The nominal rate determined by the supply and demand for loans. The nominal rate is determined by the Fisher equation: it is the equilibrium real rate plus expected inflation The term structure of interest rates Term- time of maturity Term structure of interest rates- relationships among interest rates on bonds with different maturities Expectations theory of the term structure- the n-period interest rate is the average of the current one-period rate and expected rates over the next n-1 periods Savers are risk averse and demand higher returns to compensate Term premium- extra return on a long-term bond that compensates for its riskiness; denoted by the greek letter tau

Yield curve- graph comparing interest rates on bonds various maturities at a given point Inverted yield curve- downward-sloping yield curve signifying that short-term interest rates exceed long-term rates usually as a result of unusually expected large drop in interest rates

Yield curve reveals the expectations of people who trade bonds. These are good forecasts because bond traders are well informed about interest rates Default risk and interest rates Bonds with higher risk pay higher rates because default risk makes bonds less attractive to savers Sovereign debt- bonds issued by national governments Bond rating agencies- firms that estimate default risk on bonds Junk bonds- ratings below BBB High yield spread- difference between interest rates on BBB and AAA corporate bonds with 10 yr maturities

Two biggest reasons for differences in interest rates: maturity and default risk Other two: LIQUIDITY and TAXES Municipal bonds- bonds issued by state and local governments. There is no tax for these bonds as opposed to federally issued bonds, but they do tend to pay lower interest rates. Institutions who do not pay a tax usually take out bonds with federal government because taxes do not apply to them